Draft legislation could have potentially substantial tax impacts to partnerships in real estate and other industries. The legislation is meant to close tax loopholes that proponents say permit wealthy investors and large corporations to use pass-through entities to avoid tax liability. Critics point to a host of unintended consequences that could have ripple effects across many industries. However, partnership tax law is notoriously hard to regulate.
Whether all or some of the draft legislation makes it through to law, real estate partnerships could see substantial changes as early as 2022.
How are Partnerships Currently Taxed?
Partnership tax laws are so complex that the IRS only audits about 0.03 percent of them each year. Many corporate partnerships have tiered or circular ownership structures, which allows income to flow through to other partnerships or subsidiaries. It’s estimated that about half of all partnership income flows through to other partnerships or corporations.
Investors and corporations can and do use partnerships to lower overall tax liability; however, there’s a big difference between tax evasion and tax management. Effective partnerships use flexibility to their advantage; for example, deciding how to allocate profit and loss and how (and when) unrealized gains are taxed.
Senator Wyden’s Proposal
Among other items, potential changes to Subchapter K could include:
- Allocating debt according to profit and not using other allocation methods that would limit taxable gains for some partners.
- If enacted, this would become effective for tax years after December 31, 2023.
- Requiring the remedial method when assets are revalued, such as when partners contribute appreciated property.
- Eliminating safe harbor and substantial economic effect income allocations.
- Requiring basis adjustments to unrecognized gains under Sections 734 and 743, such as when a partner sells his or her interest or dies.
- Changing current and retired partner payments to taxable or allocable shares of income – no longer guaranteed payments.
- Removing the exception of assets held for longer than seven years as a reason to exclude gains from any distributed asset.
- Taxing inventory redemptions like sales regardless of whether it substantially appreciated or not.
- Removing the option for publicly traded companies to be treated as partnerships for tax purposes.
- Changing Section 163(j) business interest expense limitation rules to an entity-level, rather than a hybrid, approach.
If enacted, most provisions would apply to tax years after December 31, 2021 except where noted above.
There are other provisions that are more specific to partnerships owned by corporations, and several other smaller points that may only apply to a subset of partnerships. It’s important to check with your advisor about which changes could apply to you, if the legislation is enacted.
Impact to the Real Estate Industry
About half of all partnerships in the U.S. are real estate partnerships. If only a few of these proposals are enacted, partners could see a spike in realized gains rather quickly, not to mention the need to increase time spent on tax compliance.
If all or most of the provisions become law, real estate partnerships can expect changes to:
- Partnership formation
- Contributed property
- Borrowing and lending
- Profit and loss distributions
Currently, most partnerships handle tax compliance by way of Excel spreadsheets and do not incorporate complex or complicated tax calculations. That may need to change in 2022 if these proposals are approved.
Take asset revaluation as an example. Under current law, revaluing a partnership’s assets can be optional and the partnership can use any “reasonable” method to compute unrealized gain and cost recovery. Moving forward, revaluing assets anytime there is an asset contribution will be required. Furthermore, only the remedial method may be used. This generally requires more complex calculations.
Another example is basis adjustments, which will be required for all partnerships and circumstances regardless of whether there are significant unrealized gains and losses or not. Typically, real estate partnerships have substantial unrealized gains and losses spread throughout a large quantity of portfolios. Tracking, calculating, and applying the correct basis adjustment across these portfolios can become very time-consuming and cumbersome with traditional calculation methods and spreadsheets.
Soon, the real estate industry, especially middle market partnerships, may need to invest in automated technology to stay in line with the soon-to-be mandatory tax compliance. Tax technology can replace manual spreadsheets and human error and tackle large-scale calculations quickly and efficiently. As the budget reconciliation bill goes up for a final Senate vote, real estate partnerships should be evaluating how to adjust to the potential tax changes.
The draft legislation was expected to be included in a larger budget reconciliation bill, but as of this writing, there haven’t been any new developments. The budget reconciliation bill has already undergone cost-cutting since its introduction in September, and it may be up for a final vote in December. As of now, all of the above proposals are still included.